When analyzing a loan or an investment, it can be difficult to get a clear picture of the loan's true cost or the investment's true yield. There are several different terms used to describe the interest rate or yield on a loan, including annual percentage yield, annual percentage rate, effective rate, nominal rate, and more. Of these, the effective interest rate is perhaps the most useful, giving a relatively complete picture of the true cost of borrowing. To calculate the effective interest rate on a loan, you will need to understand the loan's stated terms and perform a simple calculation.

Steps

Part 1

Gathering the Necessary Information

1

Familiarize yourself with the concept of the effective interest rate. The effective interest rate attempts to describe the full cost of borrowing. It takes into account the effect of compounding interest, which is left out of the nominal or "stated" interest rate.[1]

For example, a loan with 10 percent interest compounded monthly will actually carry an interest rate higher than 10 percent, because more interest is accumulated each month.

The effective interest rate calculation does not take into account one-time fees like loan origination fees. These fees are considered, however, in the calculation of the annual percentage rate.

2

Determine the stated interest rate. The stated (also called nominal) interest rate will be expressed as a percentage.[2]

The stated interest rate is usually the "headline" interest rate. It's the number that the lender typically advertises as the interest rate.

3

Determine the number of compounding periods for the loan. The compounding periods will generally be monthly, quarterly, annually, or continuously. This refers to how often the interest is applied.

Usually, the compounding period is monthly. You'll still want to check with your lender to verify that, though.

Part 2

Calculating the Effective Interest Rate

1

Familiarize yourself with the formula for converting the stated interest rate to the effective interest rate. The effective interest rate is calculated through a simple formula: r = (1 + i/n)^n - 1.

In this formula, r represents the effective interest rate, i represents the stated interest rate, and n represents the number of compounding periods per year.

2

Calculate the effective interest rate using the formula above. For example, consider a loan with a stated interest rate of 5 percent that is compounded monthly. Using the formula yields: r = (1 + .05/12)^12 - 1, or r = 5.12 percent. The same loan compounded daily would yield: r = (1 + .05/365)^365 - 1, or r = 5.13 percent. Note that the effective interest rate will always be greater than the stated rate.

3

Familiarize yourself with the formula used in case of continuously compounding interest. If interest is compounded continuously, you should calculate the effective interest rate using a different formula: r = e^i - 1. In this formula, r is the effective interest rate, i is the stated interest rate, and e is the constant 2.718.

Your effective interest rate would be a hair over 40%. The total payments would equal $119,625, which would mean you would be paying nearly $29,625 in interest over the course of about a year and a half. Unless this is a sure bet, this is a foolishly expensive loan and should only be considered as a last resort.

The only difference between simple and compounding is that simple only charges interest on the balance owed WHILE you owe it, so if you make larger than minimum payments, the overall amount of interest paid during the life of the loan goes down. Compounding interest means that even if you make larger payments, you have still promised to repay the interest that would have accrued during the entire life of the loan, even if you pay it off in half the time. The difference between the two can be dramatic if you plan on making larger than normal payment; however, compounding may work out better if you pay late.

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Tips

There are several online calculators that you can use to calculate the effective interest rate quickly. In addition, the EFFECT() function in Microsoft Excel will calculate the effective rate given the nominal rate and number of compounding periods.